With anticipated GDP growth insufficient to sustain current market levels, Q1 Publishing's Founder and Chief Investment Strategist Andrew Mickey asserts that great expectations tend to lead to great disappointments. Although he's not foretelling a big crash, he tells Gold Report readers why it makes sense to expect the market to fall back to a fair-value level over the next six months to a year and there will still be plenty of opportunities for those in the right spot.

The Gold Report: In one of your recent articles, you suggest that even if good economic news continues coming out next year, the market is likely to drop 20% to 25%. Would you go through the logic that leads you to that conclusion?

Andrew Mickey: If we look back to the way the stock market has moved over the past 20 to 30 years, it has always been valued relative to earnings. The most common valuation for the market has 15 to 20 times the 10-year average annual earnings. That smoothes out the up-and-down years and brings you to a fair valuation—with the S&P 500 between 800 and 1000.

Granted the stock market goes much higher and much lower than that—and can stay at an extreme for longer than most investors expect—but it always returns to its fair value.

Now that so many stocks have had a great run, the S&P is up to around 1050, which means it is overvalued. The market basically has a lot of positive expectations built in. Earnings estimates are starting to rise, although all CEOs are still trying to keep expectations low. Economic expectations are rising. Expectations for everything are rising and we've learned consistently throughout the years—great expectations usually lead to great disappointments.

So as long as GDP growth is low the market will fall right back to fair value. That's why, even with the big picture news getting better, the very real risk is that it's still insufficient to hold the S&P up at 1050, 1100, or wherever it does eventually top out at.

We may not have an outright crash because everyone is still on watch, but probably a slow, steady fall over maybe six months to a year.

TGR: Are all sectors currently overpriced, or will some continue to appreciate?

AM: There will be some that will appreciate. But it won't be a case of great and greater returns like we've had. There is some great historical research done on the way stocks move. One important factor is the factors of market, sector, and stock. If you break it down, basically 50% of a stock's movement is usually tied the overall market. There's nothing you can do about that; it depends on the market. Another 30% of that stock's move depends on the sector. And the remaining 20% can be attributed to the individual company.

In other words, you can expect the initial impact across all sectors. We see it all the time when the markets go down. Just look at what happened last fall. Everything is very closely tied together. Over time though, there will be the divergence between the quality and value and all the speculative stuff.

TGR: How much focus should individual investors put on international investments versus North American-based investments in this environment?

AM: A lot of it depends on your time horizon. If you have five years or more, you can build a reasonable case for focusing 30% to 50% of your money in international stocks.

That's a very high concentration for any portfolio in any particular sector. If you're looking out that far, you definitely want to be in the emerging markets. In the short term, the falling dollar has been very helpful to some of the really large, high-quality U.S. companies.

But if we look at the massive U.S. dollar carry trade right now, we can see that is going to be driving everything. We watched the Yen carry trade last for about four years and then the credit crunch forcing the sudden unwinding of it. With the U.S. dollar carry trade, it is going be even bigger, could last even longer, and the when it is unwound, the volatility and fear even bigger.

TGR: In another of your recent articles, you said that junior gold stocks offer exceptional value because they're still in the relatively early stages of recovery. With gold up 30%, major gold stocks down 15%, and junior gold stocks down 60%, you asked, "Which one would you like to buy now?"

But with the greatest opportunities for appreciation, don't those juniors also present a correspondingly greater risk? If so, how do you minimize the risks of investing in juniors?

AM: There are two ways. The first is timing and picking the bottom, which is a very tough thing to do. The other is diversification; I'd recommend owning at least five to 10 across the board. In addition, you'd want to buy consistently. The way we see it, we'll be buying gold juniors for the next two years.

We don't want to exhaust all of our capital right away. It's a lot less stressful and you don't have to be exactly right to make a fortune.

Also, when they're still deeply undervalued on a relative basis, you don't have to risk nearly as much capital. So you could make 20% in big gold stocks, but you may have missed 50% to 100% in juniors. The juniors are riskier, but the amount of capital required to earn the equivalent nominal gains is less. Risk is always relative to a lot more factors than simple percentage moves, positions sizes are as equally important.

TGR: When you're looking at juniors, do you differentiate between current producers and near-term producers? Or JV models versus royalty companies?

AM: Most of our valuations are based on traditional metrics such as net present value of future cash flows for producers. Of course, once a company is producing and we know much gold it is producing, there's a clear way to value it through the cash flow model. That's how the big money values things, so that's how you have to do it.

If you really want to swing for something with just a little bit more upside potential, maybe you select a near-term producer. There's a lot more room to value them differently because as the big money managers continue to look at gold, they're going to have to come up with ways to value those stocks.

Think of it like the dot-com days. If a company had earnings, there was a way to value it traditionally. But if a company didn't even have a chance of being profitable, traders and investors would come up with all kinds of ridiculous ways to justify lofty prices and bid them up even more. That's why the worse a company was fundamentally, the better it actually did.

That happens in all euphoric bubbles. And when it does, it will feel great, but that's also the time to start taking money off the table.

TGR: Are any of those on your radar?

AM: One junior gold company I really like right now is in that larger junior tier, and that's Nevsun (TSX:NSU; NYSE.A: NSU). The first two years it produces it will produce mostly gold, and then it becomes basically a copper-zinc mine in the out years. It's fully financed now with debt from European and South African lenders, and Nevsun is comfortable with building a mine in Eritrea, Africa.

So, that one really makes sense to me, and it's really doing well. The stock is $3 now, and the biggest risk I see to it, aside from commodity price risk, is that it gets taken out at around $5 or $6 before it realizes its full potential. In a market like this, that's a risk worth taking.

TGR: Most of those you follow are really exploration companies. Would you share some of those with us?

AM: One that has me really interested is Otis Gold Corp. (TSX:OOO). It has a unique kind of deposit at its Kilgore Gold Project in Idaho. The early exploration results have been good mixed in with the occasional high-grade greatness, but I don't think the market completely understands what it may have at this point.

It's similar to past discoveries in Nevada in that it has small pockets of high-grade gold. Otis has discovered just one of those pockets so far, but that pocket has maybe 500,000 to 750,000 ounces of gold—and that justifies the current market cap of around $15 million excluding everything else.

It's fairly valued at that point if the company stopped all exploration right now and did nothing else. But if this is like the Round Mountain mine in Nevada, which also has pockets of very high grade gold in a large low-grade deposit, has already produced 10 million ounces and with almost 2 million ounces of reserves left.

You never know, of course, but at this point, the company is really cheap based on what is known and there's all kinds of potential. Since we start looking at things with a risk-first approach, we like the low downside mixed with the truly unlimited upside. The company's drilling. The results will be coming out over the next few months. And we'll soon have a better picture, which, at this point, can only add value to the company. It just seems like the right time.

TGR: So the market's basically only valuing the current pocket and there may be several more?

AM: That's what it seems like. There's no premium at all built into the exploration upside at this point.

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